MAILBOX: Post-GFC high inflation expectations consistently surprised on downside. Why will it be different now?

In his daily Premium note to subscribers, BizNews founder Alec Hogg said: “Inflation in the US is back at levels last seen in the early 1980s. Where America goes, the world follows. Looking back, it’s predictable.” Community member Pieter Laubscher responds below, saying he would be convinced were it not for two key missing variables. — Stuart Lowman

A brief note on the current inflation scare

Inflation has spiked in the US economy (and elsewhere) in recent months. This spike follows on the unprecedented economic shock in 2020 tied to the Covid-19 pandemic, when the global economy ground to a halt for almost six  weeks, including subsequent intermittent lockdown measures. This disturbance of normal market forces and production value chains permeated the global economy and are still doing so. Hence, the supply bottlenecks in many producer value chains, which have powerful price raising impacts.  

On the demand side, particularly in the US, consumers have saved more (inter alia because of reduced expenditure on travel) and benefited from substantial direct macro-economic support measures. The economy is rebounding from a deep crisis, which spurs entrepreneurial flair in adapting to the Covid-19 world. Combined with a comprehensive infrastructure spending programme, investment demand is picking up. The negative output gap that has developed in 2020 has closed in a matter of months (albeit that this is a matter demanding additional research). 

All through this the Fed continued with aggressive asset purchases (so-called quantitative easing), which has boosted the US money supply (a process described by some economists as producing money out of thin air).  This money creation process, in turn, has touched the nerves of particularly older-generation economists who lived through the high-inflation 1970’s stagflation period.

These are the core elements of current worries about inflation lifting its ugly head after years of dormancy. To be true, the spike in inflation is unsettling, particularly the magnitude thereof. So yes, central banks should be on high alert and they are. The foregoing narrative is quite comprehensive and anyone looking back to the 1970s and the money creation and inflation consequences that happened then will be able to put forward convincing arguments that the US (and by extension, the world) is facing a new inflation era, where the Fed does not act preemptively.  

I would be convinced, were it not for two key missing variables in almost every piece I have read recently warning about inflation ahead.

Quantitative easing is different  

First, quantitative easing is not the same as the monetising of fiscal spending witnessed in the 1970s. The latter causes a permanent increase in the money supply growth. In the former case, this is temporary, as the Fed’s balance sheet is boosted. Why this difference you may ask, as any institution that sold government securities in the secondary market (and bought by the Fed), indirectly financed government spending?

Yes, this is true, but it now follows the monetary policy rationale in stimulating economic activity. In the 1970s, the direct financing of government spending by central banks triggered an ongoing money-creation process. The government spending was a direct stimulus to the economy; it boosted the money supply and in the financial markets this led to new rounds of credit creation and what followed was a money-price spiral (augmented by a wage-price spiral).  

With quantitative easing it is different. The institutions that sold the government securities purchased by the Fed had to be the channel along which credit creation (required in the second round to cause a more persistent increase in money supply growth) happens. For this to transpire, the financial institution and any counterparty — mostly big corporates wanting to do fixed investment — have to strike a deal, both parties with profit motives in mind (yes, banks are also driven by profit motives). The corporate needs to assess risk on normal terms; would the eventual returns justify the cost of the credit? Well, interest rates are low, chances are good.

Yes, but what about the general real economic growth outlook? Without speculating what may happen this time around, in the post-2009 period, the growth outlook was not good and the result was that the credit creation and stimulus to the real economy did not happen. What did happen with the cash is a topic for another day. Furthermore, it was not only the corporate sector that turned risk averse, banks themselves found it hard to extend the credit (read Lacy Hunt’s Hoisington newsletter,

The velocity of the money supply

The second missing variable in the equation and all current inflation mongering, is the important role of the velocity of money in the inflation process. Here the economic identity (not theory, simple fact in any free-enterprise economy), MV = PT (with M = money supply; V = velocity of the money supply; P = general price level; T = real economic activity) has to hold. The rate at which the money supply in the economy turns around is an important structural condition in the inflation process. It is a complex variable, with elements such as leveraging/deleveraging, financial sector architecture and innovation being key drivers.

Without going into detail, this variable is at historic lows in the US (see chart). Money supply growth has shot up, but has already peaked (first argument above; see chart). Arguably the money velocity is low owing to the extent of  deleveraging in the wake of the Covid-19 shock (and may even be worse compared to the post-GFC period?). Furthermore, the BASEL III regulations enacted during the aftermath of the GFC may effectively constraining financial innovation (even if only for the time being).

Returning to the equation of exchange, should one adopt a subdued medium-term real economic growth outlook for the US and the world — as the IMF and World Bank do, and the current author buys into — the current spike in inflation can only be temporary (even abstracting from the temporary raw material shortages and price spikes). This is particularly true for the US, with the money velocity at historic lows and little near-term prospects for it to accelerate meaningfully. In a subdued real economic growth environment (medium-term), the quantitative easing real economic link is unlikely to be fully operational as banks and corporates assess their respective risks, very much like the post-GFC period. Then high inflation expectations were consistently surprised on the downside. Why would it be different now?

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